By: economicsens

economicsens — Sun, 07 Mar 2010 18:28:59 +0000

A very interesting question, especially as many retired persons keep their savings in relatively low-risk long-maturity fixed income instruments in the expectation of higher interest yields. It is tru that the Fed has lossened the monetary policy somewhat and reduced the short-term rates somewhat to avoid the effects of sub-prime lending crisis induced uncertainty over defaults. The long-term rates of interest should not be low just because the short-term rates are. The long-term rates on interest are determine by the forces of demand and supply in the market for long-term funds. While a decline in the short-term rates would have a sobbering effect on the lonterm interest rate because the short and long-term markets are not water-tight compartmnents, the more basic reason for long-term rates remaining low must be weak demand for long-term funds as compared with demand. China, The Arab Emirates and Japan have too many US dollars to invest for the long-term: they are not merely parking short-term surpluses they have. China has been running a continously high and rising current account surplus with the US. It is unlikely that they are seeking only short-term deployment of their rising, huge forex reserves. The Japanese are used to very low rates of ineterst in their own countries for decades. The petroleum exporters are holding dollars which they can not utilize for prchase of US goods in the next few years. So, the supply of long-term funds in the US markets is huge. On the other hand, US corporations appear to be remaining cash rich and no mood to borrow in the market to finance long-term capital expenditure. Though the us ECONOMY HAS A LOW, RATHER A NEGATIVE , savings rate the glus of savings in sian countries are picking up lon-term dollar assets. Since for long the US dollar has been the most favorite international currency/ financial asset to hold, there is difficulty in selling dollars/ dollar assets when the US dollar itself is depreciating against the stronger currencies like the Euro. There is an imbalance in the international monetary system as a result and the long-term ineterest rates in the US are unable to go up. If they do, the flow of funds from abroad increases all the more.
The above may not be a fully satisfactory answer; but this is what I think is probably the underlying dynamics.
You may like to see the following notes ( somewhat outdated), thoughquoted from sources lsited below:
Notes: 1. Long-term interest rates that serve as the benchmark for fixed-rate mortgages are declining once again, with 10-year Treasury note yields falling through the 4-percent mark. Why is this happening with short-term interest rates rising so consistently and the Fed voicing concern about an overheated housing market? There are several reasons that long-term rates have fallen in the past two months, and some big names think they’ll fall even more.
Inflation is a key factor in interest rates, both on the way up and on the way down. The eight increases in short-term interest rates over the past year have brewed confidence that the Fed’s efforts are ensuring modest inflation for years to come. The irony is that rising short-term rates have actually contributed to the decline in long-term rates.
Long-term interest rates have also benefited from a steady diet of foreign money flowing into U.S. securities markets. The dollar has suddenly been looked upon more favorably among foreign investors, with the rejection of a European constitution fueling the latest dollar rally and pushing the greenback to an eight-month high against the euro. When dollars are purchased, much of that money is then invested in Treasury securities, which helps to depress yields further.
Another contributor is the prevailing pessimism about the direction of the economy, and not just the U.S. economy. Japan and Germany, the second and third largest economies in the world, both have lower bond yields than the United States and are seeing anemic economic expansion — if any at all. The high quality of U.S. government bonds, along with yields that are higher than what is available in some other countries, makes Treasury yields appealing on the world stage.
One theory is that if China’s economy slows significantly, this would dampen the demand for commodities, smothering the key element of inflation. Lower inflation is music to the ears of bond investors, and they command lower yields as a result.
Bond investors also have a renewed interest in the quality of bonds. Integral to this assessment are the ratings assigned to corporate bonds by agencies such as Moody’s, Standard & Poors and Fitch. Recent rating downgrades of both General Motors and Ford sent many money managers scurrying into a safer investment haven, with Treasuries a recipient of some of that money.
Repositioning by traders who were caught flat-footed as bond yields declined has also had an effect. With traders stampeding into Treasuries to cover their losses, this accelerated the decline in yields, particularly as the 10-year Treasury note neared 4 percent.
The declining yields have come despite the Fed’s efforts to talk up long-term interest rates, such as Alan Greenspan’s remarks about the "conundrum" of low long-term rates in the face of repeated increases in short-term interest rates. Lately, the talk has taken on a more-ominous overtone for homeowners and home buyers, with the Fed sounding repeated alarms about the speculation in the housing market. Greenspan mentioned the "froth" of the housing market and the likelihood of local housing bubbles. On May 27, Fed Governor Roger Ferguson said, "However, in some markets the most prudent judgment is that the growth of house prices will slow from the rapid pace experienced most recently." But some titans of the bond world think yields could go even lower.
Bill Gross, managing director of Pacific Investment Management Company and the manager of the world’s largest bond fund, had forecast in his widely read Investment Outlook that a range of 3 percent to 4.5 percent on 10-year Treasury notes would be seen over much of the next three to five years. Morgan Stanley’s chief economist Stephen Roach wrote, "At some point over the next year, I wouldn’t be shocked to see yields on 10-year governments test 3.5 percent."
2. How are short- and long-term interest rates different?
The Federal Reserve Board controls the federal funds rate. The Federal Reserve Board (Fed) has the power to raise or lower the federal funds target rate (Fed funds rate), which in turn influences the market for shorter-term securities. The Fed funds rate is the rate banks charge other banks for overnight loans. The Fed may raise the rate to keep inflation in check or lower it to stimulate the economy.
Long-term rates are market driven. Long-term interest rates, as represented by yields of the 10-year or 30-year Treasury bond, tend to move in anticipation of changes in the economy and inflation.
What causes interest rates to rise and fall?
Economic factors influence interest rates. Both short- and long-term interest rates are affected by economic factors such as inflation, the strength of the U.S. dollar and the pace of economic growth.
For example, strong economic growth can lead to inflation. If the Fed becomes concerned about inflation, it may attempt to cool the economy by raising the Fed funds rate, as it did in 2004 and 2005.
On the other hand, if the economy slows down, the Fed may lower the Fed funds rate to stimulate economic growth, as we witnessed in 2001-2003. Similarly, economic factors also affect long-term interest rates. For example, over the summer of 2003 and then again in the spring of 2004, long-term interest rates rose from historic lows as the economy showed signs of strength.
It should be noted that short- and long-term interest rates don’t necessarily move in tandem. While short-term rates rose in 2004 and 2005, long-term rates remained relatively low.
References :
http://www.bankrate.com/brm/search/story-savings.asp
http://www.franklintempleton.com/retail/jsp_cm/sales_tools/feature_prog/tax_free/pub/int_rate_article.jsp

Comments on: Why current liquidity keeps low long term interest rates?

By: economicsens